Risk management is becoming increasingly important to advisers given the nature of the markets in the past few years.
Today, traditional ‘safe haven’ investments like gilts are struggling to keep pace with inflation, leaving advisers with the arduous task of finding decent returns that match a client’s tolerance for risk.
To help lighten the burden, outsourcing tools like risk-rated funds were launched to give advisers a helping hand in their search for a client solution. As the name suggests, each fund is rated according to the risk it takes, ranging from lower risk and lower volatility to higher risk and higher volatility.
These funds are typically marketed with a description such as ‘balanced’, ‘cautious’ or ‘growth’. Alternatively, they are assigned a numerical value that matches risk levels set by a third-party risk-rating company, such as BITA Risk or Distribution Technology. Once an adviser has reviewed a client’s finances and appetite for risk, a suitable risk-rated fund can then be assigned.
RDR solutions
While outsourcing risk management investments has its appeal, the sector as a whole is rather more complex. The introduction of the RDR produced plenty of talk on the added pressures faced by advisers to find suitable investments at a low cost, which increased the desirability of outsourcing aspects of investment decisions to external experts to save time and money.
But with there being no such thing as a perfect pre-packaged solution given clients have vastly different investment expectations, fears have been raised about the consistency of risk-measuring strategies and their all-round suitability.
In January, former watchdog the FSA announced plans to clamp down on risk-rated funds amid fears that advisers were relying too much on third-party risk ratings without carefully scrutinising each provider’s criteria. These calls were followed in April by the regulator’s predecessor, the FCA, which voiced its concerns about the lack of consistency between products, (although it was encouraged by improvements made to analysis tools).
Says who?
Detractors of risk-rated funds have long claimed these vehicles are oversimplified. Because there is no standard measure for risk, the same fund can be given different ratings depending on which system is used. This level of subjectivity has attracted plenty of criticism, particularly as definitions of risk can vary greatly depending on past experience and perception of investments.
As a result, the differences between funds with similar rating levels can vary significantly. Chart 1, for example, shows the current asset allocation of the lowest risk fund profiles offered by F&C and Old Mutual.
F&C’s Lifestyle range consists of four different risk profiles – Defensive, Cautious, Balanced and Growth – and has allocated 45 per cent of its Defensive portfolio to equities and 37 per cent to fixed income. In comparison, Old Mutual’s Spectrum range’s lowest risk offering invests 28 per cent in equities and 56 per cent in fixed income.
At the other end of the risk spectrum, Chart 2 focuses on the most volatile vehicles currently offered by F&C and Old Mutual.
F&C’s Growth fund invests 93 per cent in equities, compared with Old Mutual’s 80 per cent equity allocation, although both plough a similar amount into the riskier emerging market sector.
Small print
These charts illustrate the discrepancies that can be found among seemingly similar risk-rated funds. They also serve as a reminder to advisers to scrutinise each provider’s offering rather than trust that such funds can be accurately matched to clients following the completion of a questionnaire.
One of the most important factors is to understand how each provider measures risk. For example, some base their evaluations on the past performance of asset classes, whereas others factor in projections. The debate surrounding this has caused plenty of heated discussions in the industry.
Given the way markets perform – particularly in the past few years – some argue that it is impossible to predict the performance of any asset class, while others say relying on historic data is an ineffective way to determine future trends. Another decisive factor is centred on the timescale of analysis, as those who focus on short-term performance are likely to see higher levels of volatility than those who use longer-term analysis.
The majority of providers are consistently developing their risk-rated funds and will regularly review asset allocations as markets change. In many cases, fund managers are also asked to update the fund’s risk profile if it has strayed too far from its original rating, although advisers are also accountable for keeping tabs on market developments.
Accountability
The rising popularity of these funds is a testament to their growing importance under RDR regulations. The fact that risk-rated funds are seen as transparent in many instances and cost-effective overall adds to their appeal, with some providers also offering tax-efficient benefits by enabling investors to move between funds without triggering capital gains tax liabilities.
If all these positive factors are utilised effectively, the trend for risk-rated funds will continue. Advisers should always be sceptical when filtering through investment options for clients and this scepticism should continue when assessing the various factors that differentiate funds in this category.
Provided you apply due diligence on the funds and do not shoehorn clients into inappropriate ratings, these funds can be suitable for specific client needs.
Five questions to ask
1. How does each provider risk rate its funds? Though some assume that the measuring of risk is standardised, each fund house applies differing ratings based on its assessments.
2. What time frame best suits your client? The riskiness of any given fund will vary according to the potential length of your client’s investments.
3. Is one questionnaire enough? Clients can occasionally exaggerate their appetite for risk, which is why it is important to use a combination of different risk-profiling tools to fully assess their limits.
4. Does the provider’s concept of risk match your client’s wishes? The fund house may market a vehicle as low risk, but upon closer inspection its definition could be entirely different to what you or your client deem risky.
5. What does the fund offer in terms of tax benefits? Some funds have the advantage of being tax efficient by enabling investors to move freely between funds without them being liable for capital gains tax.
